Wednesday, June 11, 2014

Valeant Pharmaceuticals Part II: GAAP and non-GAAP accounts

In Part 1 I introduced Valeant Pharmaceuticals and its business model which is to acquire pharmaceutical companies, strip them of their research expense and earn very high gross margins on sales.

This has become a hugely successful stock, however you could not tell by looking at the GAAP accounts. Here is the P&L for the last five years, latest on the left, courtesy of Capital IQ.

For the Fiscal Period Ending

LTM

12 months

Mar-31-2014

12 months

Dec-31-2013

Reclassified

12 months

Dec-31-2012

Reclassified

12 months

Dec-31-2011

Reclassified

12 months

Dec-31-2010

Reclassified

12 months

Dec-31-2009

Currency

USD

USD

USD

USD

USD

USD

Revenue

6,577.6

5,765.4

3,480.4

2,427.5

1,181.2

820.4

Other Revenue

5.6

-

-

-

-

-

Total Revenue

6,583.2

5,765.4

3,480.4

2,427.5

1,181.2

820.4

Cost Of Goods Sold

1,784.6

1,528.5

890.9

636.8

352.1

218.2

Gross Profit

4,798.6

4,236.9

2,589.5

1,790.6

829.2

602.3

Selling General & Admin Exp.

1,545.3

1,305.2

756.1

572.5

256.4

167.6

R&D Exp.

194.3

156.8

79.1

65.7

67.9

47.6

Depreciation & Amort.

-

-

-

-

-

-

Amort. of Goodwill and Intangibles

1,326.0

1,248.7

865.6

530.1

219.8

104.7

Other Operating Expense/(Income)

37.7

41.1

18.1

4.1

89.2

-

Other Operating Exp., Total

3,103.2

2,751.7

1,718.8

1,172.3

633.4

319.9

Operating Income

1,695.4

1,485.2

870.7

618.3

195.8

282.3

Interest Expense

(935.5)

(844.3)

(481.6)

(334.5)

(90.1)

(25.4)

Interest and Invest. Income

8.2

8.0

6.0

4.1

1.3

1.1

Net Interest Exp.

(927.3)

(836.3)

(475.6)

(330.4)

(88.8)

(24.3)

Currency Exchange Gains (Loss)

(24.3)

(9.5)

19.7

-

0.6

0.5

Other Non-Operating Inc. (Exp.)

-

-

-

7.5

-

-

EBT Excl. Unusual Items

743.9

639.5

414.8

295.3

107.6

258.5

Merger & Related Restruct. Charges

(969.5)

(923.7)

(501.8)

(170.8)

(253.3)

(35.6)

Impairment of Goodwill

-

-

(12.8)

-

-

-

Gain (Loss) On Sale Of Invest.

3.9

5.8

2.1

22.8

(5.6)

17.6

Gain (Loss) On Sale Of Assets

(10.2)

(10.2)

-

5.3

-

-

Asset Writedown

(734.9)

(783.2)

(212.9)

(132.9)

-

-

In Process R&D Exp.

(12.0)

-

-

-

-

(59.4)

Legal Settlements

(142.5)

(192.5)

(56.8)

(11.8)

(52.6)

(6.2)

Other Unusual Items

(133.6)

(50.2)

(26.8)

(25.9)

(32.4)

-

EBT Incl. Unusual Items

(1,254.9)

(1,314.5)

(394.2)

(18.0)

(236.3)

175.0

Income Tax Expense

(398.4)

(450.8)

(278.2)

(177.6)

(28.1)

(1.5)

Earnings from Cont. Ops.

(856.5)

(863.7)

(116.0)

159.6

(208.2)

176.5

Earnings of Discontinued Ops.

-

-

-

-

-

-

Extraord. Item & Account. Change

-

-

-

-

-

-

Net Income to Company

(856.5)

(863.7)

(116.0)

159.6

(208.2)

176.5

Minority Int. in Earnings

(4.8)

(2.5)

-

-

-

-

Net Income

(861.2)

(866.1)

(116.0)

159.6

(208.2)

176.5

It is that net income line at the end that sort of gets you. There are losses in all years except 2011 and large and increasing cumulative losses. The $866 million loss in calendar 2013 is a surprising number.

The losses are not quite so bad on an EPS basis because of a massively increasing share count, but these are hardly typical of a company with such a rapidly increasing stock price.

The losses however are net of vast "merger and restructuring charges", "asset writedowns" and "legal settlements" - so called "one-offs".

In 2013 merger and related costs were $923 million, asset write-downs a further $783 million and legal settlements were $192.5 million. These amounts constitute well over 100 percent of the loss recorded.

Net of these costs earnings are going up very nicely. The company actively encourages you to look at it this way - and the market has adopted that guidance (as reflected in the stock price).

Moreover this is precisely how they present it in analyst conference calls. Here is a slide from the 4Q 2013 conference call:

Note that the cash EPS reported ($6.24 per share profit) is considerably more attractive than the GAAP EPS (a loss of $2.70 according to the press release or Capital IQ).

And herein is the rub. Do you want to believe the GAAP EPS (in which case this company is a loss-making disaster) or do you want to look through the GAAP EPS and see what management directs you to, their definition of "cash EPS"?

In other words do you believe in the GAAP accounts or some non-GAAP accounts?

There is another way of saying this. To believe in the GAAP accounts you need to believe that the "one-off" charges are reasonable and truly one-off. [They are truly vast - so this matters.]

There is a possibility that the whole Valeant exercise is something from the Wizard of Oz. Profits are going up nicely if you pay no attention to that man behind the curtain - the man being the large restructuring and one-time items.

It would be an awful for investors if Valeant made its ferociously profitable budgets by putting any unwanted expenses (recurring or otherwise) into the "one-off" bucket.

And this is where we will start our long examination of Valeant. We want to work out whether the one-off charges are reasonable (in which case this is a great company) or whether they are inflated (in which case this is a Wizard-of-Oz-style con-on-the-market).

8 comments:

Those financial results you are showing for 2009 and 2010 are really legacy Biovail's not legacy Valeant's. Not a small oversight. Biovail was the surviving entity in that merger, but in effect it was acquired by Valeant and taken over by its management team. Makes much more sense to start with the legacy Valeant baseline. I think you have the same issue with your stock chart.

I see where you are going with the GAAP vs Non GAAP comparison, but I think at the very least you should add back the amortization of intangible assets from acquisitions, a non cash expense that is a function of purchase accounting. GAAP purchase accounting for acquired intangibles (and subsequent amortization) does not capture economic reality, at least in my opinion.

The easiest review for any complex financial statements is a "the cash flows don't lie" analysis. The actual cash flow from ops in the first quarter was 76% of the "adjusted cash flow" from ops, vs. just under 50% in the prior two quarters when cash restructuring expenses were higher following the B&L close. You can see repeatedly following major acquisitions that the adjusted cash flow number converges with the reported number as restructuring charges wind down, as you would expect if the charges are truly "one-time." See 2Q12 and 1Q13 as examples.

This pattern suggests that in 2Q the actual cash flow should be very close to the reported cash flow since there should not be significant cash restructuring expenses - since they break out the expensed (not cash) restructuring charges you can track them to the specific acquisition and get a good sense for where they are heading.

If my analysis is right then it could be a painful time to be short. But I could be wrong!

If the restructuring charges are not "one-time," it's tough to explain the convergence between actual cash flow and "adjusted" cash flow every time restructuring charges wind down following major acquisitions. See 2014-1Q, 2013-1Q, 2012-2Q as examples 2011-4Q as examples. When the restructuring stops, you do have impressive cash flow.

Next quarter should be even closer as B&L restructuring winds down and nothing major ramps up. Could be a painful quarter to be short.

The sustainability of organic growth and the low tax rate is much harder to analyze. But Pearson does really eat his own cooking, and will have to do so for a while if you read about his employment contract in the proxy.

Mr. Mcknuckles, I agree that pharma cos generally expense R&D whereas Valeant's "R&D" comes through the cash flow statement in the form of acquisitions. But that does not lead me to the conclusion that it is appropriate to burden Valeant's earnings power with the amortization created through purchase accounting. The creation of intangibles, and the resulting amortization is created by the modeling assumptions (monte carlo probabilities of sales, cost of capital, etc) of the accountants. In my experience accountants err significantly towards overstating the accounting amortization as compared to real economic amortization. (Conveniently the tendency to overstate acquisition intables reduces goodwill which would later be subject to impairment tests...)

To your point Valeant "deserves" a lower p/e relative to companies that expense all their R&D on the income statement (vs. Valeant's on the cash flow statement). Those companies' reported earnings are fully burdened. In either case your p/e makes an implicit assumption on the future returns on R&D.

I would argue that while it is unconventional, the Valeant "R&D" model is more transparent because you can easily compare the cash spent on acquisitions (have to include assumed debt) and on restructuring over time vs. the incremental cash flow the company generates...and the cash on cash returns are in the low-mid teens, well above cost of capital. That's not the case for the rest of the industry's "organic R&D"

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